This time China’s property bubble really could burst

By George Magnus

Beijing’s reluctance to enact stimulus programmes is unlikely to hold, says George Magnus

Chinese property is the most important sector in the global economy. It has been pivotal in the country’s economic development, provided lucrative business for industrial commodity producers from Perth to Peru, and been the backbone of the surge in world exports to China. In the past few years, predictions that the sector was about to implode at any moment have not been borne out – but now is the time for the world to pay attention. Property activity indicators have been trending lower since mid-2013, and the downturn in the sector now threatens to turn into a bust. At best, China is entering a deflationary phase at a time of global fragility.

The default risks in the weakly regulated shadow banking sector – and the rapid rise in local government debt – are real, and property-related. Yet the government and the central bank have tools to limit the short-term consequences; they have already deployed debt rollovers, bank bailouts and recapitalisations.

The greater risk to China lies in the pervasive consequences of any property bust. Property investment has grown to account for about 13 per cent of gross domestic product, roughly double the US share at the height of the bubble in 2007. Add related sectors, such as steel, cement and other construction materials, and the figure is closer to 16 per cent. The broadly defined property sector accounts for about a third of fixed-asset investment, which Beijing is supposed to be subordinating to the target of economic rebalancing in favour of household consumption. It accounts for about a fifth of commercial bank loans but is used as collateral in at least two-fifths of total lending. The booming property market, moreover, has produced bounteous revenues from land sales, which fuel much local and provincial government infrastructure spending.

The reason things look different today is the realisation of chronic oversupply. As the property slowdown has kicked in, housing starts, completions and sales have turned markedly lower, especially outside the principal cities. Inventories of unsold homes in Beijing are reported to have risen from seven to 12 months’ supply in the year to April. But when it comes to homes under construction and total sales, the bulk is in “tier two” cities, where the overhang of unsold homes has risen to about 15 months; and in tier three and four cities, where it is about 24 months.

The anti-corruption crackdown, often targeting individuals who have built up ostentatious property wealth, has poured cold water over the market, in which, according to a recent investment bank report, the richest 1 per cent of households is estimated to own about a third of residential property. Elsewhere, the tightening of credit terms, including funding costs for property developers, especially in the shadow banking sector, is taking its toll. Rates of return on commercial property and infrastructure, and cash flows for developers and local government, have been deteriorating.

The crunch in the property market, and for the economy, will come when land and property prices fall more broadly across the country. Official data still show that property prices in 70 cities were 8 per cent higher in March than a year ago – but prices have actually fallen since the end of 2013.

If activity levels and prices weaken further, Beijing’s resolve not to respond with traditional stimulus programmes is unlikely to hold. We should expect a potpourri that might include: extra spending on infrastructure and environment programmes; faster urbanisation in inland and western provinces; some relaxation on restraints on homebuying, such as mortgage deposits; and, ultimately, new monetary easing.

Such steps may provide financial markets and the economy with some short-term relief. But if Beijing goes too far it will undermine the essential strategy of rebalancing the economy, in which case the negative economic impact would be larger and last longer. China is different from the west in many ways but the real economic effects of a burst property bubble are the same the world over. Beijing will have to cope with them in the next two years but the rest of us should be prepared for the deflationary consequences in a still fractious global recovery phase.

The writer is the former chief economist of, and now independent economic adviser to, UBS.

China’s current leadership is committed to building a more balanced model, and believes that the market must play a “decisive role” in achieving that. But, while stronger market discipline is needed in some areas, Chinese officials should be under no illusion that free markets are a panacea for the financial sector. Indeed, China’s current economic imbalances partly reflect the dangers created by competition in credit markets.

Even before the 2008 global financial crisis, China’s annual investment/GDP ratio was running at an exceptionally high 40%, and economists were calling for a transition to more consumption-led growth. But the huge credit stimulus introduced in 2009 drove the economy further in the opposite direction. The investment ratio rose to 47% by 2012, and construction now accounts for 30% of all output. Total credit has risen from 130% of GDP to 200%, with both bank loans and “shadow bank” credit expanding rapidly.

Both China and the global economy benefited from that stimulus, which helped prop up overall demand in dangerously deflationary times. But it has led to significant wasted investment in heavy industry, real estate, and urban infrastructure, and leaves China facing the challenge of deleveraging and working out bad debts.

In many areas, improved market discipline does have an important role to play in addressing the structural causes of imbalance. Wasteful construction investment is encouraged by the under-pricing of rural land. The lack of a normal ownership relationship between the central government and state-owned enterprises (SOEs) allows the latter to pay minimal dividends and over-invest in business expansion. Caps on interest rates on bank deposits result in household savers supplying a large subsidy to corporate borrowers. And SOEs have better access to credit from state-owned banks than private companies do.

But the belief that financial liberalization will provide an easy route to a balanced and stable economy is a delusion, as Japan’s experience in the 1980’s illustrates. As Joe Studwell argues persuasively in his book How Asia Works, neither Japan nor South Korea based its successful economic development on free markets in credit supply; instead, they relied on the deliberate direction of credit toward industrial development rather than real estate or consumption.

When Japan relaxed constraints on its banking system in the 1980’s, the result was an enormous real-estate boom and subsequent bust, followed by two decades of slow growth and deflation. China’s per capita income is still only about a quarter of Japan’s in 1990; it would be a tragedy if it suffered a similar setback before completing the path to developed-country living standards.

One striking feature of the Chinese economy, however, is that real estate and urban infrastructure development – high-rise housing, grand transport projects, convention centers, sports stadiums, and museums – already play a far more important role than they did in Japan and South Korea at comparable stages of economic development.

This reflects the interaction of two distinctively Chinese factors and one inherent feature of all banking systems. The first Chinese factor is the authorities’ focus on “urbanization” as an end in itself, rather than as a byproduct of industrialization. The second is China’s decentralized approach to economic development, with strong competition between regions and cities often focusing on prestige urban infrastructure projects.

The universal feature in this mix is the fact that banks everywhere can create private credit, money, and purchasing power that did not previously exist, and they have a natural bias, if not constrained by public policy, to allocate it to fund real-estate developments, which drive rising land prices.

These factors will drive construction booms and busts even if obvious market distortions are removed and market discipline is tightened. The pre-crisis Irish and Spanish banking systems proved just as capable as Chinese state-owned banks at funding excessive real-estate construction.

So, even as China introduces greater market discipline to a largely positive effect, it must plan to constrain credit creation with policy tools that were missing in the advanced economies before the 2008 crisis. Caps on loan-to-value or loan-to-income ratios on real-estate loans should be used aggressively. Capital requirements for banks should reflect higher risk weights for real-estate lending than banks’ private assessments of credit risks suggest are appropriate.

The People’s Bank of China should maintain reserve requirements for commercial banks to contain credit creation, rather than reject them as old-fashioned, as occurred in the advanced economies in the decades before 2008. Credit provision by shadow banks needs to be tightly regulated. The credit cycle is too important to be left to free markets.

China thus faces a difficult challenge. It must undergo a transition not to the Western model that produced the 2008 crisis, but to an entirely new model that combines elements of market discipline with strong public-policy constraints.

How smoothly that transition occurs matters for the whole world. By the early 2020’s, China’s GDP will be $20 trillion. If the credit/GDP ratio reaches 250% by then, total loans and debt securities would equal $50 trillion, which is more than three times the total of US mortgage debt in 2008. Today, much of that debt represents claims within the state sector – owed, for instance, by SOEs to state-owned banks. But, as the private sector develops, SOEs are subjected to hard budget constraints, and the external capital account is opened, this huge credit mountain will create increasing global financial vulnerability.

One hopes that the Chinese authorities understand the dangers as well as the benefits of free financial markets better than advanced-economy policymakers did ahead of the 2008 crisis. If not, another crisis – far more severe than the last – may become inevitable.

SIZE DOES MATTER

Banks too big to fail, but not to jail

The threat of imminent United States criminal charges hanging over Credit Suisse has further highlighted the danger to Switzerland’s economy of one of the country’s big banks going bust.

On Monday, US Attorney General Eric Holder said no company was “too big to jail” and pledged to pursue any institution that breaks US laws. His comments sparked rumours that he was specifically referring to Credit Suisse, which is under investigation for alleged tax evasion offences.

It has emerged that the bank has adapted its “too big to fail” strategy to deflect any damage arising from criminal charges away from the group as a whole. A special holding company, CS International Advisors, was set up last December to house all US client accounts that fall under the investigation.

“Under this construct, the group and its parent company would be responsible for paying fines, but the new subsidiary might bear the weight of any criminal indictment,” Peter V Kunz, an expert in international corporate law at the University of Bern, told swissinfo.ch.

“This is important because the US, in all likelihood, could not tolerate any Credit Suisse subsidiaries operating in the US if the parent company has been issued with a criminal indictment.”

CS International Advisors may have been created by the bank as a sacrificial lamb for the US Department of Justice, speculated Kunz.

“In addition to issuing stiff financial penalties, the DoJ needs a symbolic scalp to show that they are being tough,” Kunz said. “Credit Suisse is dangling just such a trophy in front of them.”

In short, the holding company resembles a hastily constructed garden shed at the end of the garden designed to be obliterated by a storm while protecting the main building.

Banks act

Six years on from the financial crisis and seven from the first rumblings of the transatlantic tax evasion row, Switzerland’s biggest banks are still struggling to re-engineer themselves into fitter enterprises, better equipped to deal with such blows.

Driven on by demanding regulators, UBS and Credit Suisse have shown no lack of effort or will to shed billions of francs worth of risky assets and substantially swell loss absorbing capital reserves.

For example, after the 2011 rogue trading scandal, UBS slashed its investment banking business and vowed to halve the CHF300 billion of risky assets that were sitting on its books by 2016.

But both are still deemed too big to fail, and as such, pose too big a threat to the country’s economy.

It is easy to understand why neither institution, along with Zurich Cantonal Bank (ZKB) - the other systemically relevant institution - could be allowed to go bust.

What is too big to fail?

So-called systemically relevant banks are those that are deemed so large and offer such vital financial services to the population that their collapse would cause major problems for the rest of the economy.

Such vital services include retail deposit and savings accounts, mortgage loans and lines of credit to companies – the finance that greases the wheels of business and households.

When a financial institution has captured a large share of this domestic market, its bankruptcy could cause chaos.

Governments and regulators also take into account the number of people who are employed domestically by such banks. The prospect of tens of thousands of workers losing their jobs all at once is hard to stomach.

Then there is the value that these institutions add to the domestic economy as a whole to be taken into consideration. Profits generated by services offered by banks add up to a large chunk of the gross domestic product whilst, in normal times, corporations and their employees contribute a large slice of taxes.

UBS and Credit Suisse were named as ‘too big to fail’ banks from the onset, but ZKB was added to the list by the Swiss National Bank in November, 2013.

On May 7, Finma released estimates of how much capital reserves UBS Credit Suisse will have to set aside (capital ratios) by 2019, when too big to fail laws fully come into effect, and how much of their own trading can be financed by debt (leverage ratio).

Based on the current state of the banks’ books, UBS would have a minimum capital ratio of 19.2% and a leverage ratio of 4.6% while the smaller Credit Suisse would be set a capital ratio of 16.7% and a leverage ratio of 4%.

However, Finma stressed that the estimates are likely to change as the banks continue to shed risk.

Worth to the economy

UBS claims to reach one in three Swiss households with retail accounts, mortgage loans and other credit. More than 40% of all Swiss businesses and one in three pension funds use the services of Switzerland’s largest bank.

Credit Suisse has 1.8 million domestic clients spread among its retail, asset management and wealth management businesses. It also has CHF95 billion ($108 billion) share of residential mortgage loans on its books out of a total of around CHF690 billion across all Swiss banks.

ZKB claims to have cornered between 6-8% of the household loans market with almost CHF70 billion in outstanding residential mortgages. Between them, all three banks currently employ more than 50,000 people in Switzerland while supporting many other jobs indirectly.

Just before the financial crisis struck, the combined balance sheets of UBS and Credit Suisse were six times larger than Switzerland’s entire economic output. That ratio has now shrunk to two and a half times gross domestic product, but the loss of just one bank would still leave a large hole in Switzerland’s economy.

New plumbing

In addition to shedding risk and bulking up capital reserves, the two largest banks have also been moving to reorganise their group structures.

While exact details are thin on the ground, the driving force is to bundle vital Swiss services in holding companies based in Switzerland and house riskier investment banking and US wealth management businesses under different legal constructs in Britain and the US.

The theory is that each holding company could be liquidated without affecting the others in the event of a catastrophe. The banks also hope that the Swiss Financial Market Supervisory Authority (Finma), the country’s regulator, will be impressed enough to ease up on capital requirement demands.

But Finma is so far playing hard to get, only saying that each bank has to jump through yet more (unspecified) hoops to qualify for such relief.

“The fact that a bank has created a new holding structure does not automatically result in minimum capital requirements relief,” Finma spokesman Vinzenz Mathys told swissinfo.ch. “Holding structures could count as one measure that addresses resolution and recovery requirements under too big to fail regulations, but a range of other measures also need to be fulfilled.”

ZKB, the smallest of the ‘too big to fail’ banks, does not anticipate having to change its structure as it has fewer international operations. Like Credit Suisse, ZKB is under active criminal investigation in the US for alleged tax evasion offences, but the cantonal bank is keeping its legal strategy to itself.

DANIEL GROS

MAY 8, 2014

BRUSSELS – Ten years ago, eight countries from the former Soviet bloc, together with the island states of Malta and Cyprus, joined the European Union, bringing its membership from 15 to 25. At the time, it was feared that this eastern enlargement would create tensions within the EU because new members from Central and Eastern Europe were poor and some had large agricultural sectors. Because the EU spends mainly on poor regions and on farmers, many worried that enlargement would overburden its budget.

In the end, this problem was resolved through a typical European compromise that allowed enlargement to proceed, even though the budget, as a proportion of Europe’s GDP, was reduced. Agriculture has now largely disappeared as a major item on the EU agenda. Moreover, the planning horizon under the EU’s Multi-Annual Financial Framework implies that the issue of who pays for whom has to be addressed only once every seven years.

The purpose of economic integration is ultimately to boost GDP growth and improve living standards. Judged from this perspective, enlargement has worked well. The transition countries have caught up considerably over the last decade.

In the mid-1990’s, many transition countries’ per capita GDP was only about one-quarter to one-third of that of the old EU-15 (in purchasing-power-parity terms). Some of the distance had already been covered when the new member states finally joined the EU, but the process of convergence has continued, even through the financial crisis.

The new members’ income has reached about two-thirds the level of the EU-15. Moreover, the poorest new members gained the most (in contrast to the poorest members of the EU-15, like Portugal and Greece, which are now back to income levels last seen in the 1990’s). This convergence is the reason why job seekers from the eastern member states are not overwhelming the richer EU-15 countries’ labor markets.

The fact that the new members were initially so much poorer, initially a source of tension, turned out to be a source of economic advantage for both sides, as EU-15 firms (especially German companies) could outsource labor-intensive tasks. They gained in terms of global competitive, while the target countries gained much-needed direct investment, jobs, and knowledge transfer. In purely economic terms, enlargement was clearly a mutually beneficial proposition.

Of course, other aspects of enlargement have worked less well. A large part of the aid that has flowed from the EU budget to the new member states has been used for prestige projects that enriched local construction companies. And, though this problem is not specific to the new member states – the same thing happens in countries like Italy or Greece, with their slow and inefficient administrative systems and extensive corruption – it was rendered more acute by enlargement; indeed, many of the eastern members still have lower-quality public administrations than one finds in the EU core.

Thus, enlargement should be viewed as a qualified success. One of the biggest fears, namely that EU institutions would be overwhelmed by the simultaneous absorption of ten new members, also never materialized. The new member states have integrated smoothly into the EU institutions, where they defend their national interests in much the same way as the older members. The difficulties that the EU has experienced in the last years have little to do with the increase in the number of member states, which has now reached 28.

The most important consequence of the EU’s eastern enlargement has turned out to be one that few thought about at the time: it brought the Union much closer to Russia. And, for a Russia that has become authoritarian and has seen how the EU can transform struggling transition countries into increasingly prosperous (albeit imperfect) democracies, Europe is too close for comfort. The prospect of relative prosperity and freedom proved so attractive to the people of Ukraine that they toppled a president who preferred a Russian-led “Eurasian Union” to an EU association agreement.

Unfortunately, a significant minority in eastern Ukraine does not share this “European vocation” and feels threatened by the recent turn of events. Russia supports these tendencies and has used military and other hard-power tools to stoke tensions, because its regime would be threatened by the living example of a “European” Ukraine that is democratic and prosperous.

So, ten years on, enlargement is turning out differently than expected. The internal challenges have proved manageable, but now the EU needs to confront an external challenge for which it is ill prepared. We will not have to wait a decade to find out whether the EU can help to stabilize Ukraine while confronting a Russia whose leadership feels threatened by its fundamental values of democracy and the rule of law.

Daniel Gros is Director of the Brussels-based Center for European Policy Studies. He has worked for the International Monetary Fund, and served as an economic adviser to the European Commission, the European Parliament, and the French prime minister and finance minister. He is the editor of Economie Internationale and International Finance.

Greyerz: “Eric, every day we get reminders that hyperinflation is on its way. The Congressional Budget Office now estimates that U.S. government debt will rise by $10 trillion to $27 trillion by 2024. This of course means that deficits will escalate and money printing likewise because with the U.S. running chronic deficits, no one will buy the Treasury debt. This means it all needs to be monetized, and thus bought by the Fed.

The consequences of this debt monetization will be horrendous. The dollar will collapse and interest rates will surge. This reminds me of what the world witnessed in the 1970s. To be older doesn’t always mean we are wiser, but it does give us a major advantage when it comes to experience....

“In 1972 I came to the U.K. from Switzerland and was CFO of the United Kingdom’s largest electronic retailer, Dixon's. I got my first options in the company at 1.30 pounds. Three years later those options were worth 11 pence. They were down from 1.30 to 11 pence. And I bought my first house in the U.K. in 1973.

A year after I bought my house I paid 21 percent interest on my mortgage. That was for a short time and then I paid about 18 percent for a long time. You ask yourself: How many people today could keep their homes if they had to pay 18 percent interest? Well, almost nobody.

Of course at that time there was a major recession worldwide, but in addition the U.K. had a coal miners strike and a three-day work week. The other two days there was no electricity. So if you take Dixon's, we had to sell electrical equipment such as televisions with candle-lights. Of course I couldn’t show the people that they were working.

That led to a shortage of candles. We had to get our candles from Switzerland. In 1972 inflation in the U.K. was 8 percent and in 1974 it was 16 percent. By 1980 it was 18 percent. We had a period of eight years with inflation in the mid-teens. So what happened to the currency?

In 1972 when I came to the U.K. one pound gave you 10 Swiss francs. By 1978 you only got three Swiss francs for one pound. So the pound had declined by two-thirds. Today you get only about 1.50. This tells you what happens to a weak currency in a badly managed economy. Luckily at the time the world wasn’t dependent on computers. Today a 3-day week would mean that the whole society would be paralyzed.

The reason why I am mentioning this very valuable experience is that the situation in the U.S. and many other countries is very similar to the 1970s. And the exponentially rising debt levels in the U.S. as well as many other countries over the next 10 years will guarantee hyperinflation. This will mean very high interest rates and collapsing currencies.

Of course this vicious circle will lead to higher interest rates with lower tax revenues. If we add to that problems in the financial system, with bad debt levels rising dramatically and the $1.4 quadrillion in derivatives blowing up, it’s not difficult to envisage massive hyperinflation.

But circling back to the 1970s, in 1972 when I came to the U.K. gold was $40. Over the next eight years gold went to $850. But it wasn’t a straight ride. In December 1974 gold was $204. In August 1976 gold plunged to $108. That was a massive 50 percent correction, and everyone thought that the bull market in gold was over. Then from August 1976 to January 1980 gold went up 8.5 times in price. So if we look at the price today at roughly $1,300, 8.5 times that would be $11,000.

But this is not the 1970s. Government debt and money printing worldwide are much, much greater. And virtually the whole world today is in trouble. In addition we have massive geopolitical risks. And it will not be like 1980-2000 when it comes to the gold correction. We are not going to see a similar correction after gold reaches a peak in the next few years.

At that time gold will either be money, because people will not trust paper money, or gold will be some other part of the monetary system. Therefore I don’t expect to get more than just a slight correction after this massive gold rally that we will see in the next few years.

But with regard to the short term, I still believe that gold and silver will rise to levels that few people can imagine. This is why people shouldn’t worry about the short-term price. People are holding gold to protect their wealth and they will need this protection in coming years.”

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.